Thoughts about the Oil Business

Big Whine from Big Oil

by LexPosted: Tuesday, 5/17/2011

The discussion of the so-called oil tax breaks is too often just an exercise in spin. Here is an example quoted in an article in the NY Times May 15, 2011:

“Or take prices at the pump. In a memorandum to Senate Democratic leaders on Wednesday, the nonpartisan Congressional Research Service said that eliminating the tax benefits would have virtually no effect on the price of gasoline. The impact on industry profits — the Big Five earned a robust $35 billion in the first quarter of this year alone — would be trivial.”

My thoughts:

So exactly why are these tax breaks being blamed for the high price of gasoline?

The profits of the Big Five oil companies should not be confused with those of smaller domestic independent producers, who would be seriously harmed by the elimination of these tax provisions.

The current profits accruing to the oil industry should not be confused with average long-term profits, which are in the middle of the pack for US business. The oil business is exceptionally cyclical, a basic fact which seems to be completely ignored in this discussion. When prices are high, the business does well. When prices are low, as for instance from 1980-2002, the business struggles, but nobody seems to pay any attention.

“The report also addressed one more industry claim: that ending the tax breaks for the oil companies alone would be discriminatory. Most of the breaks — deductions for well depletion, intangible drilling costs and the like — are unique to the industry.”

These two tax provisions are two out of four under discussion; by my math, that is half, not “most”. And these two provisions are not unique to the oil industry. First, they are shared with all mineral producers. Second, they are based on accounting principles which are shared with all industrial businesses:

Depletion is analogous for the mining industry to depreciation of a capital asset. Percentage depletion exists because straight-line depreciation is an accounting nightmare for an asset which might be renewed (by secondary recovery or drilling).

Expensing of intangible drilling costs is not unique either. Any business is allowed to expense the costs of a failed project – one which does not produce revenue. The oil business is allowed to expense intangible drilling costs because 1) most wells are dry (average: about 90%), and 2) even wells which do produce can run dry unexpectedly, so trying to track which intangibles could be expensed would result in another accounting nightmare.

“The exception is a deduction for domestic production, designed to encourage all manufacturing companies to invest in this country. But as the research service pointed out, industry is not going to stop drilling on American territory as long as the oil is there and yielding big dollars.”

This rather blithe statement shows a basic misunderstanding of domestic production. Smaller independent producers account for about 1m bbl/day of total domestic production of 7m bbl/day. However, 1) the production cost of domestic onshore oil is far higher than that of Middle Eastern and offshore production; an estimate (based on personal experience with deal flow) would be in the range of $35/bbl versus $10/bbl. Therefore 2) the major oil companies have largely abandoned domestic exploration; most new domestic oil is found and produced by small independent companies, who would be seriously affected by the loss of these tax provisions.

Seattle Times, May 12, 2011

“Given profits of $35 billion in just the first quarter alone, it’s hard to find evidence that repealing these subsidies would cut domestic production or cause layoffs,” Senate Finance Committee Chairman Max Baucus, D-Mont., told the oilmen.

This remark shows the same ignorance as the previously-cited one. Big Oil, whose profits are cited, has already stopped drilling on American territory, at least the onshore part of it. The tax breaks being argued over have little impact on Big Oil, but do have a disproportionate impact on smaller, independent domestic producers, who are the ones actually drilling on US soil.

Consider by comparison that Microsoft made $5b on 1st-quarter revenue of $16b. That is about 31%, a far higher profit percentage than the 9% received by Big Oil, and Microsoft is not particularly even a darling of tech investors anymore!

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